Scholastic Corp: A Novel Competitive Advantage ($SCHL)

*** Author Note: I wrote this two weeks ago and the company has since jumped more than 20% ***

Scholastic Corporation (NYSE: SCHL) is the world’s largest publisher and distributor of children’s books and a global provider of education technology products and services. The company has earned strong free cash flows of approximately $186 million per year for the last eight years, relative to a current market cap of just $945 million (for a yield of nearly 20%). The company has been aggressively repaying debt, which has declined from a D/E of 1.23x in 2001 (net debt of $595 million) to just 0.27x in the most recent quarter (net debt of $100 million). Below is a chart showing the company’s debt (red bars indicate debt + capital leases) coming down over time:

Scholastic Corp – Capital Structure, 1995 – 2Q 2012

The company’s accruals based performance metrics look weak, as a series of impairment charges and restructurings over the last four years have left earnings in tatters. The key here is to look at the company’s free cash flow (since most of the impairment charges have been non-cash, and depreciation has exceeded capital expenditures for most of the decade), which has been stellar. Moreover, the company has used its free cash flow in a shareholder friendly manner. In addition to strengthening the balance sheet by paying down debt, the company has opportunistically repurchased shares, spending $437 million to reduce share count by 12 million. The company also initiated a dividend in 2008. Here is the company’s free cash flow historically:

Scholastic Corp – Free Cash Flows, 1995 – 2Q 2012

Nearly 3/4 of the company’s sales are derived from its Children’s Book Publishing and Distribution segment and its International Segment (which largely does the same thing as Children’s Book Publishing and Distribution, but does it abroad). There are two things about these sales that I believe give it a competitive advantage.

First, the company has a unique sales channel which would be very difficult for a competitor to replicate: school-based book clubs and book fairs. The company has 65% penetration of K-8 schools in the United States, which includes monthly orders of books through the company’s catalogue, as well as week-long book fairs run through school libraries. Note also that the company is the largest school-based book club and book fair operator in Canada, the United Kingdom, Australia, and New Zealand and is growing rapidly in Asia.

The second key point here is the strength of the company’s portfolio, which includes the best known children’s series, including Harry Potter, Hunger Games, The 39 Clues, The Magic School Bus, I Spy, Captain Underpants,Goosebumps, and Clifford The Big Red Dog. It would be extraordinarily difficult for a competitor to achieve the reader loyalty of these books, and the recreate the sales channel.

Just under 1/4 of sales comes from Educational Publishing, which is the segment the encompasses the company’s production, publication and distribution of curriculum materials. This division provides another strong competitive advantage, as once a school district has chosen SCHL’s products, it would be difficult for a competitor to break into that relationship. So long as SCHL treats the district fairly and continues to provide high quality material (which it has been doing since the 1920s), there is little reason for a school district to reevaluate its decision.

The remaining (~6%) sales are generated from Media, Licensing and Advertising, which includes the production of children’s television programs and other media covering many of the titles listed above.

One negative is that the company has a dual class share structure. Company insiders own 100% of Class A supervoting shares (held by the 74 year old President, CEO, and Chairman of the Board) and 22% of the Common Stock. The consequence of this dual class share structure is that compensation packages are on the high side (the President, CEO and Chairman earned ~$4.2 million in each of the last three years, which actually understates the true value as a significant portion of this is from share options which were granted well below current market levels). I am not a fan of this, but at the very least shareholder interests are aligned with management to an extent.

With respect to threats, some might perceive Amazon.com (NASDAQ: AMZN) as a possible future threat, especially as the company works to cut out publishers and deal with authors directly. While this is a real threat, I believe SCHL’s unique sales channel provides a relatively strong moat to protect against AMZN. Furthermore, SCHL is not standing still when it comes to digital initiatives:

We are also moving forward with our plans to be a major provider of ebooks and are on plan to introduce the unique children’s ereading app and ebookstore in our school channels in March 2012. …

We also have completed the mobile versions of the free eReader app, which can be downloaded to iPad and Android devices in addition to the PC version.

Also this fall, we continued extensive demonstration testing of the app with Book Club teachers and parents at Book Fairs. These tests have reinforced the high marks and enthusiasm we have been receiving for the software. In March, we will introduce our ereading app and ebookstore to a significant portion of our school market, leading to a broad ebook launch to our teacher and parent customers for back-to-school 2012.

As we’ve said in the past, sales of children’s ebooks are still small relative to the growing adult ebook market. We are investing ahead of the demand to stake out a leading position in a market that we believe will grow substantially in upcoming years.

On a valuation basis, I see significant potential upside in SCHL given its strong free cash flows and strengthened balance sheet. Furthermore, as shareholders wait for value to be recognized, the company appears committed to continuing to repurchase shares, which should be richly rewarding as the company continues to generate internal CROIC in the high teens to low twenties.